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The RMB has officially been valued to a basket of currencies within a managed floating exchange rate regime since 2006, but the process of exchange rate reform, especially appreciation against the US dollar, was interrupted by the 2008 financial crisis. Now the RMB is, after the August 2015, more closely tracking a basket of currencies associated with its major trading partners, but there is still room for improvement in expanding both transparency and the role of market forces.

The People’s Bank of China does not reveal information about the way in which the RMB is valued, which has led to much speculation and uncertainty after the large depreciation that occurred in August 2015 vis a vis the US dollar. Scholars have attempted to estimate how the RMB is calculated. We know that the RMB is calculated against its trade currencies, but little about the importance of each currency in the basket. Complex mathematical calculations can be applied to historical data to tell us which currencies in the basket are most important. For example, Wang and Xie (2013) show that correlations between the RMB and other currencies reveal that the dollar is the most important currency in the representative basket, followed by the Euro, the Japanese Yen, and the Korean Won. Cui (2014) finds that the weights of the US dollar, the Japanese yen, the Singaporean dollar and the Russian ruble are positive in determining the value of the RMB between 2007 and 2013, with the dollar weighted at 86% of the RMB basket on average.

In recent months, China’s real effective exchange rate, or the weighted average of the exchange rate compared to a basket of currencies, has been rising, indicating an overall real appreciation of the Chinese currency. In terms of specific currencies, we have mainly seen a depreciation in the Chinese yuan with respect to major currencies from 2015 forward; over the most recent period, the RMB has appreciated with respect to the Euro into 2015 and then slightly depreciated, depreciated a great deal with respect to the dollar, and somewhat depreciated with respect to the Japanese yen. So, what does this mean?

First, a bit of context. Chinese officials devalued the RMB with respect to the dollar in August 2015, for the first time in years, and this was said to be a one-time adjustment that would revalue the RMB in market terms. Since we don’t know what the valuation model looks like, we have to take their word for it. After this point, the RMB has continued to devalue, and implied volatility in the USD/CNY exchange rate spiked in months following the August shock. It seems likely that, if the RMB valuation mechanism has been shifted to a more market based mechanism, it might have more closely tracked the Euro, which had been in seeming freefall against the dollar through 2014 yet appreciated against the RMB during this period, or the Japanese yen. This would mean, that, in answer to the question posed above, that the depreciation provided a pressure value against an increasingly overvalued Euro or yen.Recommended by Forbes

Second, what might happen in the future? The stunning uncertainty produced last August, coupled with the economic downturn, led to an estimated $1 trillion in capital outflows last year. China’s leadership attempted to improve market signals in response to the panic. In December of 2015, the China Foreign Exchange Trade System (CFETS) RMB Index was launched by the PBOC to reflect the RMB movement against a basket of currencies. This is a trade-weighted index which includes 13 currencies, the dollar, euro, and the yen, as well as the currencies of Hong Kong, the U.K., Australia, New Zealand, Singapore, Switzerland, Canada, Malaysia, Russia and Thailand. The CFETS RMB Index doesn’t have to move within a fixed band, but can be used as a reference when market makers submit central parity rate bids, assuming market makers use this index rather than the USDCNY Index. Introducing the index appears to have improved transparency to some extent, but some analysts are not fully confident that the PBOC will not switch back to a closer dollar parity. It is also unclear to what extent market forces will truly play a role in determining the exchange rate. After all, the central bank continues to manage foreign exchange and has previously intervened in markets to prevent undesirable fluctuations in the RMB. Some questions remain, such as, at what point will the central bank stop intervening in the foreign exchange market? Will time reveal a commitment to maintaining stability in the CFETS RMB Index, or will volatility re-emerge?

It seems clear that officials understand there is room for improvement in the exchange rate valuation. Now it is a question of how those improvements will be made, and which improvements, under a potential need for tradeoffs (eg, marketization versus stability) will be emphasized. In the short run, questions remain about whether the exchange rate will be strongly impacted by a Fed rate hike or the recent Brexit vote. The latter is already being viewed as a litmus test for China’s exchange rate stability. To some extent, how stable and reflective of markets the current exchange rate regime is has yet to be proven.